Evaluating investment risk

What we don't know can hurt us. When it comes to investing, investing too conservatively for our goals can be just as damaging as investing too aggressively. How can individuals strike the balance between risk and return in selecting among different types of investments such as stocks, bonds, and mutual funds?

Measuring fluctuating values

The tendency of an investment to fluctuate in value is known as volatility. Many people tend to oversimplify volatility: they think an investment is risky if it can change in value and safe if it doesn't change. In reality, there are different degrees of volatility. In addition, volatility is affected by how long the investment is held. Moreover, an investment that doesn't fluctuate in value may still hold other risks.

Five ways to measure volatility

Standard Deviation

-- is a statistical measurement that shows the likelihood of above or below average returns, as well as their distance from the average return. This is the classic "textbook" measure of volatility. What is being measured is how widely an investment's returns fluctuate over time. Looking over the long term, standard deviation provides evidence of the relationship between risk and return.

Adding and subtracting the standard deviation to the mean return gives us the range of returns that we could expect 67% of the time. For example, based on returns since 1926, we would expect that in any given 12-month period, there would be a 67% chance that the return for the S&P 500, an index comprising 500 of the largest companies in leading industries of the U.S. economy, would fall somewhere between a gain of 30.4% and a loss of 10.04%. As you can see, this is quite a wide range. At the same time, long-term government bonds would be expected to return between a gain of 15.39% and a loss of 3.95% in 67% of 12-month periods.

As you might expect, historically stocks have both the highest level of volatility and the highest average annual return. Treasury bills, generally regarded as the most risk-free investment, combine the lowest volatility with the lowest average returns. In theory, a mutual fund with greater price volatility is more likely than other funds to show larger losses in the future. One problem with this measure is that it assumes that prices are normally distributed over a bell-shaped curve. In practice, they are not. Still, standard deviation can be a useful first step in determining mutual fund risk.

Beta

-- measures volatility of a mutual fund compared to a benchmark (for instance, the S&P 500) that represents the market as a whole. The market is given a beta of 1. A fund with a beta higher than 1 would be more volatile than the market, and would therefore offer greater upside and downside potential. For example, a fund with a 1.2 beta should move 20% more than the market as a whole. If the market goes up 10%, the fund should go up 12%. Similarly, a fund with a beta of 0.8 would be less volatile and increase only 8% in a market that has increased by 10%. The same percentages would hold true if the market declines.

The problem is finding an index that represents many mutual fund portfolios. For example, the volatility of the S&P 500 has little bearing on a gold fund. Nevertheless, the simplicity of beta, a single number that is easily understood, has contributed to its popularity. Alpha, a related measure, represents the relationship of beta to performance over the past three years. Here we compare the fund's actual performance with the performance predicted by beta.

Largest Monthly Loss

-- is the greatest decline in share price for a particular fund for any one-month period. Unlike many measures, this one looks at the performance of the fund's portfolio. It does not, however, compare that return with the market.

Down Market

-- refers to the relative performance of a mutual fund during a bear market. Since downside risk is a great concern to many investors, comparing down market returns will indicate how quickly and effectively fund managers deal with inevitable market declines.

Sharpe Ratio

-- seeks to measure the relative reward associated with holding risky investments. The higher the ratio, the greater the return for the same amount of risk. With decreasing returns, as the ratio declines, so does the reward for assuming more risk.

Total Returns from 1926-2014*

Stocks

Long-Term Government Bonds

T-Bills

Annualized Average

10.2%

5.7%

3.6%

Best Year

60.0 (1935)

42.1 (1982)

14.0 (1981)

Worst Year

-41.1 (1931)

-12.5 (2013)

0.0 (1940)

Standard Deviation

20.0%

9.6%

3.1%

*Based on returns for the period from 1926 through 2014. Stocks are represented by the total returns of the S&P 500. Bonds are represented by a composite of the total returns of long-term government bonds, derived from yields on long-term Treasuries (maturities of 10+ years), and the Barclays Long-Term Government Bond index. T-Bills are represented by a composite of the yields of 3-month Treasury bills and the Barclays 3-Month Treasury Bellwether index. Past performance is not a guarantee of future results.Sources: Wealth Management Systems Inc.; the Federal Reserve; Barclays Capital.

Commonsense risk management

Despite the SEC's and the mutual fund industry's search for tools to explain investment risk, the complexity of risk remains a daunting obstacle. There is no single number or ratio to provide a comprehensive and predictable result. The best thing for investors to do is to assess their risk tolerance based upon their goals, financial condition, time frames, and comfort levels. In addition to personal preference, there are several rules of thumb.

Choosing investments to fit your needs

Mutual funds are available that span the risk spectrum. Be realistic about your goals and the time you have to meet them. A single 22-year-old can probably afford more risk than a 65-year-old retiree. Your financial professional will pose questions designed to help you assess your risk tolerance. It's up to you to understand the risks involved in your investments.

Diversification

Modern Portfolio Theory mathematically demonstrated that putting your eggs in a variety of baskets can reduce overall risks, even if all the baskets themselves are risky. One of the benefits of mutual fund investing is diversification through a wide variety of investments. Stock funds that concentrate either in a small number of stocks or in a single industry will generally experience higher volatility. That's why sector funds offer opportunities for increased returns along with increased risk.

Long-Term Investing

If we go back to standard deviation, we see that volatility is greater over short time periods. Stock returns have averaged 10.2% since 1926. If you were a long-term investor, you would have experienced many steep climbs and a few steep drops, but overall you'd be ahead.

The questions to ask are: What is your time horizon? How much can you afford to lose in the short term? Can you afford not to pursue growth to outpace inflation? And how comfortable are you accepting short-term losses while seeking long-term gains?

Dollar Cost Averaging

If you are a long-term investor, dollar cost averaging can help reduce market timing risk. By investing regular amounts at regular intervals, your cost per share will average out over time. If you believe that the market will rise over the long term, then the expensive shares you buy at the top of one cycle will be offset by the cheaper shares you buy when the market corrects.

Dollar Cost Averaging does not assure a profit, nor does it protect against a loss in a declining market. This plan involves continuous investment regardless of fluctuation in price levels. You should consider your financial ability to continue purchasing through periods of low price levels.

Finally, perhaps the best advice is not to invest in anything you don't understand.

Investments in mutual funds and stocks are subject to fluctuation in value and market risk, including loss of principal. Bond investments are subject to interest rate risk so that when interest rates rise, the prices of bonds can decrease and the investor can lose principal value. Mutual funds are offered by prospectus. Please consider the charges, risks, expenses and investment objectives carefully before purchasing a mutual fund. The prospectus, which contains this and other information about the mutual fund, can be obtained from a financial professional. Read the prospectus carefully before you invest or send money.

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